ACCA F5: Chapter 7 - Budgeting 1

1 Purpose of budgets - a quantitative plan prepared for a specific time period. It is normally expressed in financial terms and prepared for one year. 1) Planning - A budgeting process forces a business to look to the future. This is essential for survival since it stops management from relying on ad hoc or poorly co-ordinated planning.2) Control - Actual results are compared against the budget and action is taken as appropriate.3) Communication - The budget is a formal communication channel that allows junior and senior managers to converse.4) Co-ordination - The budget allows co-ordination of all parts of the business towards a common corporate goal.5) Evaluation - Responsibility accounting divides the organisation into budget centres, each of which has a manager who is responsible for its performance. The budget may be used to evaluate the actions of a manager within the business in terms of the costs and revenues over which they have control.6) Motivation - The budget may be used as a target for managers to aim for. Reward should be given fo operating within or under budgeted levels of expenditure. This acts as a motivator for managers.7) Authorisation - The budget acts as a formal method of authorisation to a manager for expenditure, hiring staff and the pursuit of plans contained within the budget.8) Delegation - Managers may be involved in setting the budget. Extra responsibility may motivate the managers. Management involvement may also result in more realistic targets.

2 The performance hierarchy - long term, looks at the whole organisation and defines resource requirements. For example, to develop new products in response to changing customer needs. - medium term, looks at the department / divisional level and specifies how to use resources. For example, to train staff to deal with the challenges that this new product presents. - very short term, very detailed and is mainly concerned with control. Most budgeting activities fall within operational planning and control. For example, a budget is set for the new product to include advertising expenditure, sales forecasts, labour and material expenditure etc.

3 Behavioural aspects of budgeting - Manager evaluated on ability to achieve budget in the short term. Manager will be criticised for poor results. For example, if spending exceeds the limit set - Job related pressure, Can result in poor working relations with colleagues, Can result in manipulation of data.

3 Behavioural aspects of budgeting - Manager evaluated on ability to reduce costs and increase profit in the long term. For example, a manager will be prepared to exceed the budgetary limit in the short term if this will result in an increase in long term profit. - Less job related pressure, Better working relations with colleagues and Less manipulation of data

3 Behavioural aspects of budgeting - Manager evaluated mainly on non-accounting performance indicators such as quality and customer satisfaction - Similar to profit conscious style but there is less concern for accounting information

3 Behavioural aspects of budgeting Subsequent studies by Otley (1978) involving profit centre managers in the UK coal mining industry contradicted Hopwood’s earlier findings. One particular area of difference was that the UK study showed a closer link between the budget-constrained style and good performance. The manager evaluated on a rather tight budget-constrained basis tended to meet the budget more closely than if it was evaluated in a less rigid way.

3 Behavioural aspects of budgeting A budget set at current achievable levels. This is unlikely to motivate managers to improve but may give more accurate forecasts for resource planning, control and performance evaluation.

3 Behavioural aspects of budgeting A budget set at a level which exceeds the level currently achieved. This may motivate managers to improve if it is seen as attainable but may also result in an adverse variance if it is too difficult to achieve. This must be managed carefully.

4 Conflicting objectives Examples:- The company wishes to increase shareholder wealth. This should involve the use of NPV but divisions are assessed on accounting targets such as profit.- Similarly shareholder wealth is determined by the long term but divisions are set short term targets (see below).- Managers reject projects that dilute divisional performance, even though they beat company targets. Resolutions:- Some companies try to insist that projects are assessed using NPV but then still impose accounting targets.- Give managers share options so they focus on shareholder wealth.- Use performance measures that encourage the division to accept projects which meet or exceed company target. For example, residual income

4 Conflicting objectives Conflict:-Divisions may compete for limited financial resources when setting budgets Resolution:- Prioritisation- Negotiation and compromise.

4 Conflicting objectives Conflict: - Managers cut R&D to hit short term targets but erode long term competences- Managers reject projects that are “slow starters” even though they have positive NPV Resolution:- Use more non-financial indicators that focus on key long term issues such as quality, productivity, etc.- Link bonuses to longer time periods.

4 Conflicting objectives Conflict: - The risk of budgetary slack. This is when managers participate in target setting and, as a result, make the budget too easy to achieve. Resolution: - Greater scrutiny of budgets- Better training of managers